Clever timing keeps cash on track

By THIS IS MONEY
Updated:

 

Booming stock markets have given a good ride to investors in index-tracking funds. But if shares slide the going could become rough. Some economists forecast that the Wall Street bubble is about to burst and that UK markets will be hit by the fallout.

But if it happens, it need not be a disaster for investors with trackers. The key factor is timing. Those planning to invest lump sums in index-tracking funds could reap the benefit of buying while prices are low.

Others who already have money in a tracker should take a five-year view because history indicates that markets rise in the long term. For example, the FTSE All-Share index of more than 800 stocks has risen 95% over the past five years. And the FTSE 100 is up 145% in the same period.

Steve Russell, UK strategist at HSBC Bank, says investors should 'wait on the sidelines and start buying aggressively if the US market cracks'. He adds: 'We anticipate it will slide by at least 20%, causing the UK market to fall further. You could start putting in your lump-sum when the FTSE 100 index of leading companies falls below 6,000 or try to be clever by waiting for more downside. 'You will reap the benefit when the UK market recovers from these lows later this year.' The bank's view, Russell added, is that Europe and Japan are expected to follow a similar course, but the US is a different story. Shares on Wall Street have soared to incredible heights and when the bubble bursts they will tumble to more realistic levels and settle at lower valuations.

One way to reduce volatility is to spread exposure. John Turton, financial adviser at London-based Best Investment, suggests that investors should consider a global portfolio of index funds giving holdings in the UK, Japan, the US and Europe. He favours using Legal & General, which offers a variety of tracker funds with low charges and a choice of investing £30 a month through a savings plan or a minimum lump sum of £500.

The idea behind index tracking funds is simple. They aim to track the performance of a chosen stock market index and most leading fund management groups run at least one of them. Some focus on tracking a UK index and others attempt to mirror overseas indices such as the Dow Jones in the US, the Nikkei-225 in Japan or the MSCI Europe. There are two main systems for tracking an index.

The first is called 'full replication' which involves buying every share in an index in accordance with its proportionate value. This means that if the market value of a company represents, say, 4% of the total value of companies in the index, it will take 4% of the fund. The second approach is called 'sampling' where the fund manager buys a selection of stocks represented in the index so as to match its sector weightings or the index's composition of small, medium and large companies. Once the chosen system is in place, there are no other investment decisions. This is why tracker funds are called passive.

The absence of active management means that charges can be kept low, typically 0.5% each year with no initial charge. This compares with the more usual initial 5%, plus a 1.5% annual charge for an 'actively' managed fund. Alan Gadd, head of savings and investments at HSBC, is an index tracking enthusiast. He says: 'The long-term picture favours UK index funds because it gives them exposure to UK plc in a value-for-money format. Overseas trackers are suitable only for sophisticated investors.' Ian Millward, financial adviser at Chase de Vere in Bath, Somerset, is more cautious. He recommends avoiding the FTSE 100 because a small number of companies represent a large part of it and the problem is deepening.

Vodafone, with German rival Mannesmann on board, will account for about 14% of the FTSE 100 index. This means that one firm has a powerful influence over a tracker fund, making it a far riskier investment proposition. Millward says: 'Trackers are high risk because all their eggs are in a few baskets. Anybody invested in a FTSE 100 tracker should switch to a much broader FTSE All-Share tracker.'

Stewart Reed, fund manager of Gartmore UK Index, says: 'The performance of index trackers has been better than bonds or building society accounts over the past five to 10 years. 'There are no guarantees of returning capital, but history shows that the return on equities is higher than bank deposits in most cases. 'And with only a minority of active fund managers beating the index, it is worth many investors giving up the flexibility of an active fund for the computer-generated precision of an index tracker.'

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